Costa Rica exchange rate to stay at ₡500 into 2013

The flood of dollars into Costa Rica will accelerate in 2012 and 2013. 

Private sector direct investment in the country is at $1.5 billion for the first half of 2012, according to the Costa Rican Central Bank, and should easily top the target figure of $2.3 billion for 2012. 

But added to this will be approximately $2 billion in public sector financing, including $924 million in funds yet to be disbursed to the government and government entities under multilateral loans, and another $1 billion of Eurobonds recently approved by Costa Rica’s Legislative Assembly to refinance existing government debt and substitute lower interest rate dollar credit for more expensive colón-denominated government bonds.

Some of these dollars will go to refinance existing dollar-denominated Costa Rican foreign debt and will not be changed into colones, but nearly all the foreign direct investment and some of the government Eurobond money will. 

The Central Bank administers the exchange rate using “bands”: floor and ceiling exchange rates that will trigger the Central Bank’s entering the exchange market to buy or sell dollars to maintain the rate between the bands. Currently, the irrelevant upper band exchange rate is set at ₡700 to the dollar, and the very relevant lower band at ₡500 to the dollar. 

Because there is an up to ₡10 spread between buy and sell rates, the lower buy rate can fall below 500. On Oct. 9, the Central Bank’s buy and sell rates were ₡492.39 and ₡503.11 per dollar, respectively.

Dollars exchanged for colones put downward pressure on the exchange rate. The Central Bank, with dollar reserves of $4.86 billion, has approval to buy up to $1.5 billion to build up a bigger dollar reserve cushion. These dollar purchases also are very useful to defend the ₡500 to the dollar lower band exchange rate. Since September, the Central Bank has purchased $260 million under this facility. 

At this rate, the Central Bank would fill up its reserve increase target in about five months. After that, if the Central bank wants to keep buying more dollars, it would face a choice between further increasing its dollar reserves (and becoming a bigger creditor of the United States) or issuing colón bonds to buy back the colones it generates when it buys the dollars, to hold down inflation. 

This latter approach would be inflationary in itself, because the bonds would have to pay high colón interest rates, but less so than putting the colones into the economy.

Six months into the future is a long time for exchange rate projections. There are too many economic wild cards – national and international – that make projections educated guesses at best. But it is clear that for the rest of 2012 and into 2013, pressure on the Costa Rican colón’s exchange rate versus the dollar will be downwards. 

The Central Bank can hold the ₡500 to the dollar exchange rate easily into 2013. But if nothing happens to reduce the flow of dollars into Costa Rica, that exchange rate could come under downward pressure next year, when the Central Bank and the country will have to either keep piling up dollar reserves or pay a colón inflation price to prevent the colón-dollar exchange rate from falling.